Summary of a discussion hosted by the Heinrich Böll Foundation and the Bretton Woods Project on April 24th,, 2001 in Washington, DC
by Liane Schalatek, Heinrich Böll Foundation Washington
In the face of some 1.2 billion people living in abject poverty on less than $1 a day, international organizations (mainly IMF, World Bank and WTO) and government leaders continue to focus on economic growth as the most effective way to reduce poverty. With official development assistance (ODA) in 2000 still below 1995 levels (last year, the average donor country provided only 0.24 percent of its gross national product in foreign aid), trade and financial liberalization ? both domestic financial and capital account liberalization (CAL) ? are touted as the “inevitable”(IMF economic counselor Michael Mussa) prerequisite for developing countries to partake in the open world economic system and to achieve poverty alleviation through economic growth.
In the early 21st century, international financial transactions and international capital flows have reached unprecedented levels, dwarfing global trade transactions. Last year alone, some $200 billion from capital markets flowed into 31 developing countries according to the World Bank’s Global Development Finance report. Yet, the past decade also saw some of the worst financial crises, triggered by sharp reversals of capital flows for a number of emerging and developing countries, which had previously opened up their capital accounts. Millions of people were plunged back into poverty.
While never questioning its overall benefits for developing countries, the proponents of CAL in the wake of the Asian financial crisis and the subsequent crises in Russia and Brazil had to acknowledge that CAL and broader financial liberalization at a minimum need to be properly sequenced and paced. The opponents of financial liberalization saw these crises as confirmation that CAL needs to be seriously reconsidered particularly in terms of its effectiveness to reduce poverty through economic growth.
The discussion hosted by the Heinrich BöllFoundation and the Bretton Woods Project in Washington aimed at exploring the nature and the extent of the linkages between CAL and poverty. It tried to answer questions concerning the contribution CAL is bringing to growth and whether CAL is the right tool to help developing countries and emerging market economies improve their situation. In looking at the private and public sector impacts of CAL in developing and middle-income countries, the discussion centered on the question whether CAL supports or restrains other policies aimed specifically at reducing poverty (f. ex. by prohibiting developing country governments from using pro-poor spending) and how it affects the access of small enterprises and individuals to credit. The meeting in Washington continued and brought forward a dialogue on the issue started in January 2001 in Oxford, Great Britain.
Angela Wood from the Bretton Woods Project UK focused in her introductory remarks on the need to investigate the linkages between CAL and poverty. While CAL as a policy tool is usually not specifically applied with poverty reduction in mind, there is a need for the development community to better understand whether CAL supports or restrains other policies to reduce poverty. Angela Wood questioned the opinion of IMF and World Bank analysts that financial liberalization leads to growth, pointing to analysis done by Alex Cobham of Oxford University who concluded that there is no clear evidence linking CAL to growth . Instead, CAL impacts on developing countries’ public sector by effecting a country’s ability to tax (through a competition with other developing countries for foreign capital flows) and its allocation of government spending. As a developing country needs to control the size of its budget deficits, it increases spending on debt repayments while being denied the ability of borrowing more for social spending. This is especially damaging in times of economic crisis, since the poor in developing countries are likely to be hit asymmetrically, i.e. they are less likely to profit from CAL and domestic liberalization in good times and in relative terms are hurt more in bad times and over the longer-term than their more prosperous countrymen. With respect to the private sector, CAL raises the question of credit access, particularly for individuals and small and medium-sized enterprises. Here, too, the effects seem to be asymmetrical with smaller borrowers profiting less from inflowing foreign capital but being hit hardest by rapid capital outflows, because they usually lack the option of moving their assets abroad in times of crisis and have reduced access to financial services.
In her presentation, Isabelle Grunberg, a consultant for UNDP‘s Office of Development Studies, focused on the effects of CAL on government revenues, particularly the loss of government income, both direct and indirect. With a closed-off domestic capital market, developing countries were able to create desperately needed government revenue, by requiring domestic banks to hold government bonds at low rates of interest, money creation thanks to moderately high inflation rates (“inflation tax”) and multiple exchange rates. While Grunberg admitted that those measures may not have made economic sense, she nevertheless pointed out that the shortfall of government revenues created by CAL needs to be accounted for, especially since financial liberalization, according to several UNDP studies, has failed to deliver on the promise of contributing to higher economic growth rates, which could have contributed to increased government revenues. On the contrary, because CAL demands strict market discipline with an inherent deflationary bias, governments in effect have to slow down growth, so that potential growth benefits of CAL can only be realized in the short-term.
Market discipline also constrains a developing country’s social policy, f.ex. restricting labor and minimum wage laws. Market discipline concerns can be used as political tools to limit benefits to labor. Market discipline and competitive pressures between countries have also put pressure on governments to reduce taxes leading to social spending. This is apparent in the U.S.
A further cost of financial liberalization is associated with handling increased instability. Citing a study by Morris Goldstein (now Institute for International Economics), Grunberg pointed to the quantifiable increase of financial crises following CAL, resulting in enormous economic losses for the countries affected. “Capital account liberalization costs money”, both in normal times through foregone revenue as economic slow downs and through increased demand for social spending and debt payment in terms of crises, as well as through the significant loss of GDP invariably following financial crises.
Honing in on the issue of lost revenue for countries, which opened up their capital accounts, Mark Weisbrot from the Center for Economic and Policy Research pointed to the need for central banks to increase their holdings of foreign reserves as risks and market instability increase. This usually generates additional costs since countries effectively lose revenue from foregone interest rates if those holdings were invested more favorably.
While John Williamson from the Institute for International Economics questioned the existence of strong linkages between CAL and poverty, he acknowledged that open capital markets can increase instability and thus contribute to financial crises but they will also have growth effects. He argued that it was not clear which would be bigger, the growth or crisis effect. He refuted the notion that the poor are asymmetrically affected by economic growth, citing the World Bank studies by David Dollar and Aart Kraay that the poor profit from growth as well as people being better off. He suggested that the real negative impact on the poor was likely to stem from failure to tax capital which pushed the taxation burden onto the poor. Consideration should be given to ways to tax capital abroad or to raise revenue through capital controls such as taxation on short-term inflows, for example as Chile has imposed.
Bert Ely, a private consultant on financial institutions and monetary policy, and Nancy Birdsall from the Carnegie Endowment for International Peace both suggested that some of the negative costs associated with an open capital account in developing countries may be linked to shortcomings in the progress of domestic liberalization, f.ex. with respect to the issues of corruption, tax schemes, barriers to business formation and entry, property rights and contracts enforcement. Both speakers opined that open markets for capital and goods ultimately will result in improvements for the poor, although Nancy Birdsall admitted that CAL in the short-run constitutes a source of wage inequality (with the wages of skilled labor, which compliments capital, rising faster than those of unskilled labor, thus widening the income gap). Therefore, attention has to be given to the question of how to broaden access to capital in order to reach a “complementarity between human and physical capital.” Birdsall commented that the Dollar and Kraay paper was not convincing because it failed to look at wealth, just income effects.
Angela Wood questioned whether capital account liberalization was to some extent unavoidable if countries had liberalized trade accounts, since with liberalized trade accounts money could be easily transferred abroad. Therefore, maybe the appropriate discussion about the connection between CAL and poverty has to center more on the question of how far and how fast capital accounts should be liberalized as well as the question of how to ensure that countries benefit equally and evenly. Amar Bhattacharya argued that to liberalize or not was not an “either-or” option, since the impacts of vulnerability are not just seen at the macroeconomic level but also on government and bank and corporate sector balance sheets. “Because the punishment is always greater than the crime,” more emphasis needs to be put on safeguards to ensure a country will share the benefits of CAL while mitigating its risks. “One has to get into the pool with the appropriate life jacket,” he commented. Bhattacharya concluded that it is necessary to determine what the preconditions for safety are, keeping in mind that these cannot all be immediately realized to assess what regulations are necessary (including market based controls). He pointed out that the policy response must be appropriate and heterodox.
Krishna Srinivasan from the IMF suggested that the possible loss of government revenue after implementing CAL would be offset by efficiency gains and that with the move away from fixed to flexible exchange rates in countries vying for foreign capital the risk of financial sector crises would be reduced. He commented that tax holidays had little impact on foreign direct investments (FDI) and that the IMF did not support them. He agreed that there was a need to understand the impact on tax revenues on a case-by-case basis. He, argued for the inevitability of CAL, giving priority to better pacing and sequencing of necessary reforms.
This contention drew sharp criticism by Isabelle Grunberg who asserted that “trying to make countries safe for CAL diverts the discussion from the costs and benefits of financial liberalization”. In her opinion, sequencing of liberalization measures is not the answer to averting financial crisis, moreover the ultimate goals still suggest full CAL. Diverting government resources into developing domestic finance systems to be able to cope with a liberalized capital account was hugely expensive. Instead, a thorough cost-benefit-analysis is necessary, which particularly takes into account the effects of instability on the poor. She invited the discussants to focus on thinking of and treating stability as a basic human right.
Jane D’Arista from the Financial Markets Centre focused her remarks on the actions of the private sector in a global financial system “that has run amok in many ways.” ODA as well as private capital flows are pro-cyclical, confounding the dilemma for developing countries in need of foreign capital.
While the private capital flows to developing countries have increased, most of the money goes to only a few countries and within those countries mostly to financial institutions with a “frightening maturity structure” of less than one year of most bank flows. Banking sector flows to developing countries are only 8 percent of the total. Much of the remainder is absorbed by rich countries’ financial institutions themselves, for example, to enable banks to invest in derivatives. Moreover, reserves have risen massively, which has served to enrich the U.S. by providing it with additional credit. Thus, the U.S. benefits most from other countries holding reserves. In D’Arista’s opinion, private capital markets will only contribute to growth if they are properly managed. Development experts should focus less on CAL, which assumes the development paradigm of export-led growth to repay foreign currency denominated debt. The latter is failing to fulfill its promise in times of falling imports in the United States, which serves effectively as “importer of last resort”.
D’Arista suggested to focus anew on national economies and their financial structures, especially the issue of credit allocation and the capacity of central banks and called for a “democratization of credit.” In her opinion, there is no shortage of available funds, but “we are not managing the pools of money we have which could do some good.” Developed countries have credit allocation schemes and schemes similar to the American credit union model, for example, should be implemented in developing countries.
Tim Kessler from the Initiative for Policy Dialogue agreed pointing out that capital flows will only benefit the poor if they go to the disadvantaged in the form of direct loans. This is particularly important since pro-poor sectors of a national economy, for example agriculture usually don’t attract foreign investment. However, schemes to direct credit are often hampered by the International Financial Institutions (IFIs) and private foreign capital. While directed credit can give opportunities for rent seeking, the IFIs should be advising governments on best practice ways of implementing transparent, market-based mechanisms.
Nancy Birdsall noted that although private sector flows into developing countries appeared small, relative to the size of their economies they were very significant. With the right policies, developing countries can attract private capital flows. She added that a very crucial problem for poor and middle-income groups is instability. Concluding she pointed out that democratization of credit was essential; it shouldn’t be controlled by the financiers themselves. A shift towards private pensions in her opinion gives a key opportunity to do so by ensuring that these important issues are raised on the boards of pension funds.
While the discussion round failed to agree on what Mark Weisbrot termed the “lowest common denominator”, namely that there shouldn’t be any forced financial liberalization, the participants acknowledged that more research and discussion is needed to understand the impact of CAL on poor people in developing countries and emerging market economies fully. Carol Welch from Friends of the Earth US suggested that further research on the linkage between CAL and poverty was needed to determine which of the various aspects previously discussed ? lost revenue, the massive amount of socialized debt, or debt servicing and its impact on social sector spending ? are most detrimental to the poor. Future discussions should center on this and on the impact of the “short-termism” of financial flows, the issue of credit allocation and access to credits and the costs of instability on the poor.
Ira Arlock, New Economy Communications, Washington, DC
Amar Bhattacharya, The World Bank, Washington, DC
Nancy Birdsall, Carnegie Endowment for International Peace, Washington, DC
Jane D’Arista, Financial Markets Center, Philomont, Virginia
Bert Ely, private consultant, Alexandria, VA
Jo Marie Griesgraber, Oxfam America, Washington, DC
Isabelle Grunberg, consultant to UNDP, New Haven, Connecticut
Tim Kessler, Initiative for Policy Dialogue, Washington, DC
Sascha Müller-Kraenner, Heinrich Böll Foundation, Washington, DC
Simonetta Nardin, International Monetary Fund, Washington, DC
Filomeno Santa Anna, Action for Economic Reform, Philippines
Robin Robison, Quaker Peace and Social Witness, London, UK
Liane Schalatek, Heinrich Böll Foundation, Washington, DC
Krishna Srinivasan, International Monetary Fund, Washington, DC
Mark Weisbrot, Center for Economic and Policy Research, Washington, DC
Carol Welch, Friends of the Earth – US, Washington, DC
John Williamson, Institute for International Economics, Washington, DC
Angela Wood, Bretton Woods Project, London